. INVESTMENT ADVISER ASSOCIATION INVESTMENT ADVISER ASSOCIATION SOFT DOLLARS WEBINAR June 3, 2010 Soft Dollar Arrangements: Commission Sharing vs. Traditional Soft Dollar Sh i T diti l S ft D ll Arrangements & Other Current Issues Monique S. Botkin Steven W. Stone Investment Adviser Morgan, Lewis & Bockius LLP Association www.morganlewis.com
Critical Elements of Commission Sharing Arrangements & Soft Dollars A t & S ft D ll • Key Concepts • Different Structures • “Research” & • Traditional “B “Brokerage” k ” • Third-Party • “Good Faith • CSAs CS s Determination” Determination • Current Issues • “Provided by” Test • “Effecting” Investment Adviser Association Soft Dollars Webinar 2 2
Polling Question #1 Polling Question #1 • Does your firm use client commissions to obtain any of the following? (check all that apply): apply): Proprietary research Third-party research Brokerage services Brokerage services Other Investment Adviser Association Soft Dollars Webinar 3
Polling Question #2 Polling Question #2 • Does your firm manage accounts investing in? Equities Fixed Income Both Investment Adviser Association Soft Dollars Webinar
At a Glance At a Glance - Research Research • Research -- Content used for investment decision-making • Research includes (in contrast to FSA stance) • Market data • Seminars and conferences • R Research excludes products and services h l d d t d i • That do not reflect “the expression of reasoning or knowledge” or • With inherently tangible or physical attributes (e g • With inherently tangible or physical attributes (e.g., computer computer hardware & accessories) Investment Adviser Association Soft Dollars Webinar 5
Examples of Research Examples of Research • N t R Not Research h • Research R h • Products that don’t reflect • Traditional research reports “expression of reasoning or analyzing performance of a y g p knowledge” g company or stock • Products with tangible or physical attributes • Financial newsletters and • Computer hardware & Accessories trade journals trade journals • Office furniture, travel expenses & entertainment • Quantitative analytical • Meals associated with attending software and software that seminars • W b it Website design, email software & d i il ft & analyzes securities Internet service portfolios • Legal expenses & Membership dues • Proxy voting services • Seminars & conferences Seminars & conferences • Except as used for investment decisions Investment Adviser Association Soft Dollars Webinar 6
Polling Question #3 Polling Question #3 • Does your firm share research with any affiliates? Yes No Not applicable (e.g., we do not have any affiliates) Investment Adviser Association Soft Dollars Webinar 7
Polling Question #4 Polling Question #4 • Does your firm pay brokers for their proprietary research with hard dollars? Yes No Investment Adviser Association Soft Dollars Webinar
At a Glance - Brokerage At a Glance Brokerage • Products and services that P d t d i th t • Relate to the execution of a trade • From when a money manager transmits an order through settlement y g g • Brokerage services • Order routing software and algo trading software • Exchange of messages among brokers, custodians, and institutions • Electronic communication of orders, allocation instructions • • Routing settlement instructions to custodians and clearing agents Routing settlement instructions to custodians and clearing agents • OMSs, based on functional analysis • Post-trade matching Post trade matching Investment Adviser Association Soft Dollars Webinar 9
Communications Services Communications Services • Information delivery • Communications services C i ti i for execution, clearing, or mechanisms are not settlement of trades can research research be brokerage • Because they do not • Dedicated lines between a broker and a money manager’s OMS reflect substantive reflect substantive • Lines between a broker and OMSs content related to operated by a third-party vendor investment decisions • Dedicated lines providing direct dial-up service between a money manager and service between a money manager and • E.g., telecom lines & a broker’s trading desk • Message services used to transmit computer cables orders to brokers for execution Investment Adviser Association Soft Dollars Webinar 10
Good Faith Determination Good Faith Determination • Money managers bear the burden in making a “good faith determination” that the amount of commissions paid is reasonable in relation to the value of brokerage & research services received • “Mixed Use” Products • Mixed Use Products Investment Adviser Association Soft Dollars Webinar 11
“Provided By” Requirement Provided By Requirement 1 1. P Providing proprietary research idi i t h 2. Paying for 3d-party research where broker is financially responsible 3. Paying for 3d-party research for which money manager is financially responsible where broker • Pays the research vendor directly • Reviews the description of the research for “red flags” that the R i th d i ti f th h f “ d fl ” th t th research is not within the safe harbor and reaches agreement with the money manager that it will use client commissions only to pay for items that reasonably fall in the safe harbor to pay for items that reasonably fall in the safe harbor • Develops and maintains procedures so that research payments are documented and paid for promptly Investment Adviser Association Soft Dollars Webinar 12
“Effecting” Test Effecting Test • Executing, clearing or settling trades E ti l i ttli t d • Directly • Clearing arrangements g g • Step-outs and prime brokerage transactions • Limited other functions – (any one, where others done by another broker) • Taking financial responsibility for trades until the clearing broker has received payment or securities • Making or maintaining records on trades per SEC and SRO rules, including blotters and order memoranda • Monitoring and responding to customer comments on the trading process • Generally monitoring trades and settlements Investment Adviser Association Soft Dollars Webinar 13 13
Polling Question #5 Polling Question #5 • Has your firm’s use of soft dollar arrangements increased over the past year? Yes No Investment Adviser Association Soft Dollars Webinar 14
Polling Question #6 Polling Question #6 • Does your firm have any commission sharing arrangements? Yes No Investment Adviser Association Soft Dollars Webinar
“Classic” (1975) Classic (1975) Trades Manager Manager Broker Broker Research Investment Adviser Association Soft Dollars Webinar 16 16
Third-Party Arrangement (1986) Third Party Arrangement (1986) Manager Research Research Executing Executing Provider Broker Investment Adviser Association Soft Dollars Webinar 17 17
“Hard Dollar” (2004) Hard Dollar (2004) $Money$ Manager Manager Broker Broker Research Investment Adviser Association Soft Dollars Webinar 18 18
Commission Sharing Arrangement (2006) Commission Sharing Arrangement (2006) Manager Research Executing P Provider id Broker Non- Executing Broker Investment Adviser Association Soft Dollars Webinar 19 19
Commission Aggregation Arrangement (2009) (2009) Manager Commission Commission Aggregator Aggregator Executing Executing Executing Broker Broker Research Provider Investment Adviser Association Soft Dollars Webinar 20 20
Emerging Focus on Best Practices Emerging Focus on Best Practices January January 2007 – November Revised 1997 – SIA Best Practices SEC March for Firms that Interpre- 1998 – ICI Engage in Soft tation tation Brokerage B k Dollar & Other D ll & Oth Takes Allocation Commission Effect Arrangements Practices September June 1998 July 2008 – 1998 – SEC – AIMR SEC, Proposed Staff, Soft Dollar Soft Dollar Guidance on Guidance on I Inspection ti Standards: the Duties and Report on the Guidance Responsibilities Soft Dollar for Ethical of Investment Practices of Brokers, Practices Company Investment Involving Boards of Advisers and Advisers and Client Directors Mutual Funds Brokerage Investment Adviser Association Soft Dollars Webinar 21 21
Focus on Mutual Fund Boards (2008) Focus on Mutual Fund Boards (2008) • Proposed 2008 Guidance would task mutual fund boards • Proposed 2008 Guidance would task mutual fund boards with asking: • How the adviser identifies the amount and types of research obtained research obtained • How soft dollar budgets are established and how brokerage allocations are made • How the adviser determines its use of soft dollars is within the safe harbor • How soft dollar products and services are allocated among • How soft dollar products and services are allocated among clients • How mixed-use products are evaluated Investment Adviser Association Soft Dollars Webinar 22
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